Can We Close the Pay Gap?

LONDON — The issue of pay ratios has become the latest front in a worldwide debate about inequality and the widening gap between the top 1 percent and everyone else. In the United States, the financial reforms of the Dodd-Frank Act contained a provision that would force American companies to disclose the ratio of the compensation of their chief executive officer to the median compensation of their employees. Yet fierce criticism from the business sector has succeeded in delaying this measure for four years — and counting.

Now the European Commission in Brussels has weighed in, with a proposal currently under discussion that the European Union’s 10,000 listed companies reveal their pay ratios and allow shareholders to vote on whether they are appropriate. This has unleashed howls of protest against the European Union’s unpopular, unelected commissioners. Fund managers have called the plan weird, and business leaders have objected that shareholders don’t want such power.
Pay ratio proposals, in fact, have a venerable history. In his 1941 essay “The Lion and the Unicorn: Socialism and the English Genius,” George Orwell advocated a limitation of incomes so that the best-paid would earn no more than 10 times the lowest-paid. But this was controversial territory, even for Orwell. A few paragraphs on, he retreated and wrote: “In practice it is impossible that earnings should be limited quite as rigidly as I have suggested.”

Several decades earlier, that Gilded Age titan John Pierpoint Morgan had endorsed a 20 to 1 ratio between the head of a company and its average worker. That same ratio was recommended in the 1970s by the American management guru Peter F. Drucker.

Yet look where we are now: In 2012, the compensation received by chief executives of companies in the S.&P. 500 index was 354 times that of rank-and-file staff.

Companies are sensitive about revealing the pay differential between the bosses and the work force partly because the gap has become so extreme. Business leaders argue that they have to offer high rewards in order to compete in a global talent pool for well-qualified executives.

After big corporations threatened to quit the country, voters in Switzerland last year rejected a referendum that would have restricted the pay gap to a ratio of 12 to 1. But the proposition still garnered 35 percent support amid a heated campaign.

The idea of a global talent pool for chief executives is, however, largely a myth. Not one of the chief executives heading up the 142 American companies in the Fortune Global 500 at the end of 2012, for example, was an external hire from overseas. There was a little movement within Europe, but over all, poaching of chief executives from abroad accounted for only 0.8 percent of C.E.O. appointments in the Fortune Global 500.

Business leaders also argue that senior managers need incentives to drive the business forward, so their compensation must be linked to the performance of the corporation, usually through the offer of big share awards for meeting certain targets. The argument that chief executive pay must be linked to the performance of the company has driven share awards ever higher — in Britain, as high as 700 percent of salary. But there is scant evidence to show a definite link between executive remuneration and a company’s success.

On the contrary, some economists say that the practice of rewarding chief executives for boosting the share price (and consequently their own compensation) makes them too short-term in their focus. The way they are paid is thus at odds with the long-term success of the company.

Moreover, the manner in which chief executives are rewarded means that it is in their interests to keep work-force wages low, in order to contain costs. This may help to explain why we have seen executive remuneration continue to rise sharply during and after the financial crisis, while work-force wages have stagnated, struggling to keep up with inflation.

Last year, the top 10 most highly paid chief executives in the United States took home more than $100 million each; most of these rewards came from shares or stock options. The survey of 2,259 American chief executives found that, on average, their remuneration had risen by 8.47 percent. At the same time, the average family income was $51,017 — little changed from the year before, and 9 percent less than its inflation-adjusted peak in 1999 of $56,080.

According to a report by the French academic Thomas Piketty and Emmanuel Saez of the University of California, Berkeley, incomes for the top 1 percent in the United States grew by 31.4 percent from 2009 to 2012, but the bottom 99 percent saw their wages go up by only 0.4 percent during the same period. The economists conclude that the top 1 percent captured 95 percent of the income gains in the first two years of the recovery.

Widening pay gaps have added to concerns about inequality and economic instability. This is one reason regulators are struggling to find ways of making remuneration fairer or, failing that, enforcing disclosure that shows how unfair it is.

Brussels has tried to do this by introducing a law that comes into effect next year that will cap bankers’ bonuses. Europe’s highest-paid bankers will have their bonuses restricted to 100 percent of salary, or 200 percent with prior approval of shareholders. This is largely a British issue, since most of Europe’s best-paid bankers reside in Britain.

But the bank bonus rule has seen banks making big efforts to get around it by allocating monthly allowances to their top bankers and executives to make up for lost bonuses. Banks argue that without global action on bonuses, they risk losing their top performers to Wall Street or Hong Kong.

There is probably some truth in this since bankers specifically tend to be more mobile than corporate chief executives. There is, however, a counterargument that bankers will now be more attracted to working in the European Union since their pay will generally be just as high and far more predictable than an annual bonus.

The European Union bonus saga is helpful in illustrating the often perverse consequences of trying to impose laws and regulations to limit top remuneration. In a similar fashion, President Bill Clinton’s campaign pledge in 1991 to restrict top salaries to $1 million is often cited as the point at which chief executive pay started to skyrocket in America — precisely because companies introduced payments of stock options to circumvent the rule.

A regulatory crackdown on high pay ratios can also hurt the very people it is trying to help. The imposition of a maximum pay ratio, for example, might see companies outsourcing the work of their lowest-paid employees, purely to make their figures look better.

But business is not immune to the public debate about inequality and pay distribution. There is evidence that big pay gaps can undermine employee morale, leading to strikes, more sick days and higher staff turnover. And pressure on corporate leaders to address large pay disparities because it would help their business perform more effectively can be persuasive.

There is an outside chance that business will reform itself, as some business leaders bemoan the pay scandals for inflicting damage on their sector’s reputation. But expecting multimillionaires to take a voluntary pay cut is a long shot. It might be more effective to introduce structures that will tackle egregious pay awards before they are made.

In Germany, for example, the unusual system of a two-tier board structure for company governance has helped prevent top pay rising as fast as it has in other developed nations. A supervisory board, consisting half of shareholders and half of employees elected by the work force, has the ultimate power over executives and sets top pay.

In 2012, employee board members at Volkswagen forced through a 20 percent pay cut for the chief executive even though the company was making record profits. They felt the C.E.O.’s pay was too high, his bonus targets too easy and that work-force wages had been held down. This was widely seen in Germany as a response to the controversy over inequality after the financial crisis.

There is a growing chorus of voices in Britain arguing for the election of employees onto company boards or remuneration committees. This could become an important theme in the run-up to the next general election in 2015, given the way public debate has already focused on falling living standards.

Top chief executives worldwide often take home far more in one year than most people will earn in their entire lifetime. Yet the International Monetary Fund has recognized that reducing inequality leads to “faster and more durable growth.” It is important that we put pressure on businesses and policy makers to develop measures to stop pay gaps opening up even further, and to share the rewards of success more fairly — for everyone’s benefit.

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The Great Divide is a series on inequality — the haves, the have-nots and everyone in between — in the United States and around the world, and its implications for economics, politics, society and culture. The series moderator is Joseph E. Stiglitz, a Nobel laureate in economics, a Columbia professor and a former chairman of the Council of Economic Advisers and chief economist for the World Bank.